Monday, January 16, 2017

Faulty Political Analysis May Lead to Investment Bubble



Introduction

When one finds oneself in a hole the prescription to get out is not to dig deeper! Many are digging deeper with the same shovel of faulty analytical techniques that led them to be wrong on the last three 2016 elections of BREXIT, the Colombian referendum, and the US elections. To compensate for being wrong, they have quickly become stock market Bulls by taking the Republican Presidential candidate’s every statement as a list of future accomplishments.

Insufficient Analysis Leads to Mistakes

Most of the time the side that either has deeper analysis or brings a superior way of thinking will have a distinct advantage.  In each of the three missed elections what started as a generally accepted expected outcome gradually lost polling support but still appeared to be dominant. There were four critical mistakes in accepting the presumed premise.

1.  Reports of trends are often behind the times, the reality is people do not freeze their views when polled. One of the most useful times I spent at the racetrack was after watching a race that did not turn out as expected. Sitting in the grandstand near a group of bettors I heard them explain how they picked the winner. Some of these lessons that I later applied to picking securities and funds include:


  • Conditions are different than the past
  • New talent vs. established players
  • Signs of improvement or deterioration which could change present and future rankings
  • Competitive mix now
  • Better prepared than other entries

Any and all of these are also relevant to political forecasting.

2.  The dataset was incomplete, missing some intensive sub-groups, e.g., “The missing barking dog,” - as per Sherlock Holmes.

3.  “Check the box mentality” is efficient, cheap, and often wrong on controversial views. Only after physical conversations including body language does one get the deep seated feelings of an individual including levels of doubts.

4. The political classes use identity politics as all-encompassing motivational decision making. This mistake came from the liberal arts instructors in our scholastic system not understanding that the concept of identity came from their algebra class when two mathematical expressions, while different, are deemed to have the same value; x+y=a+b. While at the moment they may be equal that doesn't mean that for all time they will be. Further x,y,a, and b may not be completely interchangeable under all conditions, e.g.; working at all, at low pay, high pay, receive meaningful psychic income, near retirement, starting out with or without family, living in a good city, a dangerous city, small town, rural area, have deep or little religious belief, etc. 

From an investment standpoint this is the same mistake (using over-simplistic investment tools)  as many are making investing in Index funds and other relatively fixed portfolios as a way to invest in a dynamically changing investment world.

In terms of the US elections some saw the probability of a Republican sweep including key electoral votes.  According to Barron's, my old friend Bill Priest at the time of their Round Table meeting in 2016 believed that Trump would win. Having known Bill for about forty years I am not surprised with his judgment. He looks at data deeply seeing what is actually there and what is missing. (Those traits made him a good little league baseball coach for his and one of my sons.)  

Compounding the Error

To make up for the emotional loss of face to themselves and their clients as well as their media audiences, many needed to act. Thus, they invested whatever reserves they had as well as moving out of conservative holdings into high momentum stocks. These stocks were moving on the faulty analysis of using what the winning candidate said along the way. As with the reliance on misreading poling data particularly in terms of supposed identity politics, they created a view as to what the new US Administration and Congress would deliver. 

Any careful reader of political history going back to the Roman Republic, and to our own Founding Fathers, as well as Abraham Lincoln understands that little if any of the more controversial views get executed as planned. While we all revere "Honest Abe Lincoln" one can see a fine political mind at work. In 1858 he and Steven Douglas ran for the US Senate, the campaign included seven debates moving from the northern part of their home state of Illinois to the southern portion. 

While the Douglas rhetoric remained relatively consistent, our future President modified his as he moved closer to slave owners in nearby states. From a historical standpoint it is not important that Mr. Lincoln lost that election, but it helped to split the Democratic Party in 1860, which allowed Lincoln to be elected with about 40% of the vote. Despite his under-whelming electoral tally, he showed political skills that would be needed to manage a fiercely divided government. (I have paid particular attention to his political acumen as one of my distant ancestors wrote a book on when he was an elector for President Lincoln for his second term.) Bottom line: it is a mistake to view campaign speeches as a guide to elective political successes.

Using the same mistaken identity politics as those investors trying to recover, many of them view all Republicans as fully on board with the new President. Some wiser souls have already recognized that Paul Ryan and his abilities are the keys to passage of critical legislation. I can almost guarantee the final bill presented to the President will not much look like one that could have been drafted from the campaign trail. Even if that would have been desirable one needs to take into consideration that the incoming President is a negotiator and may have announced his starting positions not his final ones. In Washington no piece of governing stands totally on its own, but rather as a negotiating item in a mix of deliverables.

The history of our Presidents is that the main items that command their attention are new events which modify past positions.

Faulty Political Analysis May Lead to Investment Bubble

Instead of looking at the tea-leaves, I urge you to concentrate on the tea-readers. Also, I seek to look at the entire dataset not the conclusions.

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Sunday, January 8, 2017

Re-Risking with Bonds, China Near-Term



Introduction

I have learned that one of the most risky periods to trade is when the market is open. Without the regular flow of transaction prices, one doesn't know if one is winning or losing. Thus, during all trading hours one is at risk to a significant price adjustment. Or to the contrary: opportunities to recognize investment profits. But some periods have been more prone than others to substantial price moves. We may be in such a period after a light volume expansion which appears to have topped out, and at the same time little in the way of successful shorting  and low volatility.

Re-Risking with Bonds

After 35 years of substantial gains, bond prices for high-quality paper experienced some falls. By year end it appears that the declines have just about slowed to a gentle fall, at least temporarily. Bond trading has attracted hedge funds and other speculative players. Many of these have taken losses as markets have signaled higher interest rates. These losses were  relatively small for un-leveraged portfolios, many portfolio managers feel that they have been insulted by "Mr. Market." They plan to get even with the market by re-risking their portfolios utilizing below-investment grade paper,  be it floating rate paper, loans, or high yield bonds. One can be concerned that they are creating the next large bubble. We should pay attention to that great portfolio manager William Shakespeare when he wrote the following words for the witches in Macbeth:

"Double, double, toil and trouble, fire burn, cauldron bubble...."

The re-risking has already begun with high yield bonds gaining +17.18% and floating rate paper +10.57% compared to 5.98% for the bonds issued by the S&P 500 participants. For a number of mutual fund management companies the appeal of this paper hopefully will add to their dominant bond funds which could be very useful to the groups, but particularly Eaton Vance*, Franklin Resources*, and T Rowe Price* among others. The flows are presumed to come from new shareholders who wish to participate in the rising interest rate phenomena. One sign of the popularity of intermediate quality bonds is that their average yield for the week fell 23 basis points vs. a fall of only 7 basis points for the previous week, according to Barron's. If interest and inflation rates grow slowly, and stay below a pre-determined yield point, many bond investors will not focus on the decline in the price of their bonds.

 At this point that breakaway yield is probably about 4%. Another concern is the likely default rate that is expected on this paper. Moody's* believes that currently the bid/ask spread on speculative issues is 60 basis points too narrow or phrased another way, Moody's expects greater default rate than the market does.
* Personally owned  or through a private financial services fund that I manage.

Must be in the China Funds Business


On the fifth of January two of the global fund industry’s leading groups announced long term commitments to the Chinese mutual fund business. Fidelity was given permission to establish a wholly owned fund management subsidiary in China. On the very same day it was announced that two arms of the Power Corporation of Canada* would become the second largest owners of the largest mutual fund company in China. Both of these two groups are long-term strategic thinkers that have successfully entered markets beyond their home and appear to the locals that they are local themselves. (Fidelity is one of the largest fund providers in the UK, Hong Kong, and Japan among others. Power Corp. has big positions in Great West Life both in Canada and US as well as Putnam and substantial investments within Europe.) While I don't know whether these Chinese ventures plan to offer domestic and international funds in China, I am impressed with the commitment these two giants have to their long-term expansion plans. Each has benefitted from multiple generations of their senior management families who have worked their way up to their current command positions. On the basis of my respect for these families and their companies, I feel in the future one can not afford to disregard China and the Chinese investors as even more portent powers in the fund business globally.

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Monday, January 2, 2017

Insights from Mutual Funds in 2016 and Their Influences in 2017



Mutual Funds are Important to all Investors

First, funds are an important part of many publicly traded markets around the world. On a global basis they hold more than $44 Trillion dollars today.

Second, funds provide more relevant disclosure than probably any other financial sector.

Third, much of the less well disclosed institutional investments are managed by people who received their early training in the mutual fund business. Large financial institutions often manage mutual funds in addition to their other accounts.

Fourth,  in most countries mutual fund boards include independent directors and in most cases those independent directors represent the majority of the directors. In the US the annual investment contracts must be approved by the independent directors. These directors  have civil liability for their actions (or the lack of action).

Fifth, most mutual funds are managed by privately owned management companies or are part of large multi-product organizations such as banks and insurance companies. However, in a number of global markets there are publicly traded mutual fund management companies. Their disclosures reveal important trends as to the profitability of money management and related information. From time to time we have found these companies to be worthwhile investments.

Sixth, with the world's growing retirement capital deficit, it is important to recognize that mutual funds are a major gatherer of retirement capital. Of the $16 Trillion invested in US mutual funds, $7.5 Trillion were in identified retirement accounts about equally divided between employer-sponsored Defined Contribution Plans and Individual Retirement Accounts (IRAs). Upon exiting from employer plans, investors often place money into IRAs. 


The total US retirement market is $25 Trillion with the Defined Benefit Pension market flat and expected to decline as employers choose to shed the accompanying fixed and growing liability There is ample scope for Defined Contribution plans to grow and could lead to an increase in the size of the mutual fund share of the market. The average individual mutual fund is currently held between four and five years, more than twice the holding period for Exchange Traded Funds. Due to the lengthening of people's retirement period it is reasonable to expect that IRAs will remain open for at least twice to possibly four times the non-retirement money in mutual funds.  

Insights from 2016

1.   In the US market there was more money entering the fund business than leaving. From first glance, most of the net gain went into Money Market funds. However this gain occurred during a time when the number of funds declined. Due to changes in regulation most of the decline occurred in the Prime Retail Money Market funds arena. Considering the emotional turmoil caused by the US election and rising interest rates, it is not surprising that money flowed into Money Market funds. While a portion of the money in these funds will never enter the long-term mutual funds arena, some will.

2.   Due to automatic reinvestment of income and capital gains, distribution funds have another source of inflows other than net sales. For the first eleven months of 2016, reinvested dividends of about $42 Billion came in from this source to Long-Term funds which meant for the eleven months the flow into Long-Term funds was positive.  

3.   Appropriately in November there were net redemptions in bond funds for the first time. The redemption rate slowed for equity funds, particularly for World Equity funds.

4.   In the shortened time horizon that many advisors and brokers are using with their accounts, they are relying on the correlation among mutual funds and ETFs.  But these are not currently working. In the performance reports issued by my old firm, Lipper, Inc, now owned by Thomson Reuters, there are twelve investment objective averages of compound performance for the last five years (through December 29th) between +11.83% and +13.80% . Nine of the thirteen were clustered at the 13% level. A nice tight group. These are funds grouped first by the size of market capitalizations within their portfolios. These include Large, Multi-Cap, Middle-Cap and Small-Cap. They are further sub divided by investment objectives into large, core and growth.

In 2016 the close correlations exploded. The Large-Cap Growth funds averaged a gain of +2.49% and the Large-Cap Value funds gained +14.93%. Hardly a tight correlation. Thus the fund selection criteria became critically important. Market capitalization did not help meaningfully in terms of the Large Cap. Actually if one ranked performance within this subset of 12 investment objectives, Large Caps where most of the money is, came in fourth behind in rising order, Multi Caps, Middle Caps and the winner was Small Caps.

Within the market cap segments, the choice of investment objective was even more meaningful. In each case the Value funds did better than the Core funds which beat out the Growth funds. Thus in the 12 fund categories analyzed, the best was the Small Cap Value funds which averaged +27.25%, compared with the previously mentioned +2.49% Large Cap Growth.

The real lesson in owning the best performing funds in 2016 was selection not correlation.

Looking Forward to 2017

1.   Though we are in a period of annual forecasts, in many respects it should be called the period of extrapolation. Most people including analysts and other pundits  draw on what they call the use of the brains, but their real pattern is elongating some past trends into the future without limit. This is natural and is discussed in a book entitled Seeking Wisdom from Darwin to Munger which was sent to me by Charlie Munger. The book ties in with the work that I have seen from Caltech; that the brain is essentially a memory device of personal experiences. Really bright people are not limited by their own experiences, they seek to learn from others' experiences current and past. That is why I say that if you slice a vein in a good analyst, an historian will bleed. Many of the published forecasts that I have seen as of today either extend the 2016 trends or one from November 9th. In my mind neither group has learned the lessons of 2016 which could be summarized as follows:

  • Search for what is not in the data.
  • Events can change perceptions.
  • Many people are not forthcoming as to their plans.
  • There is a need to learn from others with different backgrounds.
  • Doubt much you have been taught.

2.   As one who is often described as a contrarian, I need to warn that after accruing the benefits of being a contrarian in 2016, there will be some times when the apparent majority will be right. (For a while and to a limited extent.)

3.   Unless you are primarily trading, looking at new highs is not often productive of big winners. My investment strategist son suggests one should look at the new low list which could be a better hunting ground for research. He is also more focused on industries rather than large segments of the market. For me, I focus on individual management of businesses that Charlie Munger and Warren Buffett would find of interest.

4.   Many Frontier market securities and some Emerging Market stocks have been beaten up pretty hard. In selected cases their prices have much less risk within them than before.

5.   The only two fixed income categories showing double digit gains for 2016 were High Yield funds +13.25% and Emerging Market Hard Currency Debt funds +10.75%. Be careful in 2017, these are taking on equity type risks without enough equity type gains.

6.   One possible way to gauge the level of excess enthusiasm is the cost to hedge against continued growth. It has been pointed out that the cost of hedging the enthusiasm for Small Caps is that the cost to hedge the Russell 2000 is very low. Options to protect against a decline in the iShares Russell 2000 ETF  haven't been this cheap since August 2015. While there could well be technical reasons for this, one should be on guard anytime it is too cheap to hedge.

7.    One of the lessons from the election campaign is that many in the middle class and the working rich feel that the economic future is limited. In the past many of these people would have been mutual fund buyers. It is their absence from the marketplace, not disappointment with results, which has impacted fund sales. To the extent that their post-election elation is real if they come back into the market, the bears on mutual fund management companies will once again be proven wrong.  
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Copyright © 2008 - 2017
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.